A significant number of banks, insurance companies, and other financial institutions maintain partial or full interests in structured finance and fixed income securities (FIS). These securities may include, for instance, those backed by mortgages, home equity loans, credit card receivables, auto loans, and collateralized loan obligations, as well as collateralized debt obligations (CDOs) and credit default swaps on fixed income securities and CDOs of fixed income securities (collectively, FIS Portfolios). To collect value from FIS a financial institution may treat FIS as an asset which it either intends to trade, or hold to maturity and collect principal and interest payments. Regardless of whether it seeks to keep, transfer, or acquire FIS, it is important that the financial institution be able to determine the value of FIS, if not for purposes of market pricing, then for the fact that the value of held FIS will affect a financial institution's balance sheet and possibly its income statement. In addition, the reported value of FIS may affect its credit rating or otherwise influence the amount of capital necessary to maintain a given FIS or FIS Portfolio. However, given characteristic market and regulatory conditions it is difficult to appropriately value, finance, or trade FIS, regardless of the credit quality of its underlying assets or cash flows.
Changes by accounting standards boards, such as the Financial Accounting Standards Board (FASB), that govern the accounting profession will affect the perceived value of FIS by modifying the accounting standards used to determine the fair value of FIS. For example, under prior International Financial Reporting Standards, and with changes to U.S. General Accepted Accounting Principles, the value of FIS has been increasingly tied to fair value as determined by the transferability of the FIS. Under these prior accounting standards the fair value was determined by the price that would be received to sell the asset or to transfer a liability in an orderly transaction between market participants at the measurement date; however, this accounting treatment contrasted with the previous practice of many financial institutions, which involved estimating fair value using financial models that determine an expected value of FIS or FIS Portfolios. As seen in, for example, FASB Staff Position 157-4, the more recent accounting standard position has been to permit some flexibility in determining fair value in distressed market conditions or in situations where there has been a significant decrease in the volume and level of activity for the asset or liability being valued. Despite these changes, the prevailing standards continue to focus on determining the value of the asset or liability under current market conditions. As a result, the current market value of the FIS, as defined for accounting purposes, may be significantly lower than the expected value of the collection of principal and interest on the underlying securities.
In another instance, changes in market supply and demand for certain classes of securities can also affect the perceived value of given FIS. For example, difficulties surrounding the decline of securities backed by sub-prime mortgages have affected the values of FIS under fair value accounting standards. Factors such as a perceived lack of transparency, as well as the presence of securities issued by highly leveraged entities investing in FIS Portfolios (such as structured investment vehicles and conduits), have led investors to largely exit certain sectors of the FIS market. Despite attempts to increase transparency in accounting standards, the main sources of investor concern relate to an impaired ability to establish a current estimated market value for FIS, estimate future market value or maturity value for FIS, and estimate correlations between various FIS investments. As a result, investors are willing to pay less to acquire the securities affected by these concerns.
In addition to other factors, the changes to accounting standards and variations in investor demand represent forces that give rise to non-economic changes in the value of FIS. Although not generally based on the value or quality of the underlying securities (i.e., the expected amount of repayment of principle at maturity or upon default, as determined by qualitative analysis or by use of a model), these non-economic changes in value have significant accounting consequences on the holders of FIS and participants in FIS markets. In the current environment, the above factors have resulted in an increasing number of market participants having determined that the current market or liquidation value for FIS is often significantly below the expected or model-based value, resulting in the booking of substantial losses or reductions in capital resources. This, in turn, has prompted many financial institutions and other holders of interest in FIS to either sell assets (to avoid future risk of loss) or raise capital (in order to preserve or restore regulatory or rating agency capital ratios). Many financial institutions with access to the equity market have elected to raise fully-dilutive equity capital in order to shore up capital adequacy measures, rather than sell and realize non-economic losses on FIS Portfolios.
As a result, it would be advantageous to have a method for an arm's-length solution for eliminating or reducing non-economic risk that supports a higher-than liquidation value for FIS and FIS Portfolios, and satisfies financial institution auditors, rating agencies, regulators and analysts in terms of capital relief In addition, it would be advantageous to have a method that enables a financial institution to move FIS Portfolios risk from a trading account that is subject to mark-to-market valuation to a held-to-maturity account, that likely is not.